Literature Review
This chapter is designed to a totally literature review on the role that the law and its enforcement play, the empirical link between the qualities of the institutional infrastructure and the effect on the cost of equity capital.
2.1 Role that the Law and Its Enforcement Play
Empirical support for the hypothesis that legal and political institutions matter for economic growth for economic growth can be found in the work of, among others, back into the 1990s, Barro (1991) studied cross-country growth and investment regressions for 98 countries for the 1960-85 periods, and found that coups, revolutions, and political assassinations are associated with slower growth and lower investment rates. And then Barro (1996) studied growth regressions by examining the impact of democracy (as measured by the Freedom House indexes) on growth. Democracy is positively related to growth through factor accumulation: democracy is not significant when education and investment are included in the regression. A curvilinear relationship best fits the data, with partly democratic countries exhibiting the fastest growth rates. Also Mauro (1995) states that instrument for corruption is ethno linguistic fractionalization (ELF), which measures the possibility that two randomly chosen persons are not from the same ethno linguistic group, emphasizes that it could be that there is a direct effect of higher ELF leading to lower investments by slowing down diffusion of ideas and technology, http://www.ttc-switch.com/Thesis_Tips/Reference/Literature_Review/which does not have to go through institutions, then highlights the detrimental effect on investment and growth of widespread corruption among government officials and finds that that corruption has a negative effect on economic growth. Later on, Easterly and Levine (1997) have shown that ELF affects economic growth directly, and not only through institutions. This makes ELF a bad instrument. Mauro (1995) also identifies a simple positive correlation between corruption and all his other measures for institutional efficiency. This finding was supported later by Aidt et al (2005) which suggests that corruption is higher in societies already struggling with weak institutions
The capital structure literature has also directly examined the effect of laws and legal efficiency on external financing decisions. In particular, research has looked at important institutional differences such as legal contracts and their enforcement across countries and noted that this can be an important factor for firm-level capital structure. Analytical frameworks based on agency costs and residual control rights (Jensen and Meckling, 1976; Hart, 1995) are based on “adequate”– and alike – investor protection across countries. Back to the early 1990s, Harris and Raviv (1991) provide a comprehensive survey of the capital structure literature and find that debt use is positively related to fixed assets, no debt tax shields, investment levels and firm size and negatively related to cash flow volatility, growth opportunities, advertising expenditure, and probability of bankruptcy, profitability and uniqueness of product. Studies such as Hart and Moore (1995) examine optimal capital structure when investors cannot enforce legal rights.#p#分頁標題#e#
Several recent papers in the law and finance approach to corporate governance narrowed their focus on the interactions between legal institutions, financial development and growth. Rajan and Zingales (1998) explore the empirical link between financial markets and growth. Then use industry-level data to test the hypothesis that firms and industries that are more dependent on external finance tend to 留學生dissertation網(wǎng)grow faster in countries where financial markets are better developed, they assumed that “technological differences [in DEF] persist across countries, so that we can use an industry’s dependence on external funds as identified in the United States as a measure of its dependence in other countries.” In the same time, Carlin and Mayer (1998) build on the Rajan and Zingales approach to probe further into the relationships between industrial activity, financial systems and legal arrangements. They conclude that market-based finance and legal protection of investors are correlated with the growth of equity-financed and skill-intensive industries. Later on, Demirguc-Kunt and Maksimovic (1999) examine debt maturity in 30 developed and developing countries from 1980-1991 and find important differences in the use of long-term and short-term debt. Specifically, larger firms in countries with good legal systems have more long-term debt relative to assets and a longer average maturity of debt. Similarly, large firms in countries with more effective legal systems have less short-term debt. The relation between legal effectiveness and long-term debt is weaker for smaller firms. Overall, these results are consistent with the arguments of Diamond (1991, 1993) and Rajan (1992) that short-term financing is preferred when it is more likely that borrowers could defraud lenders. They find little evidence that the legal tradition (e.g., common or civil law) is important for determining the use of long-term debt relative to assets or debt maturity. They also find that, consistent with the suggestion of LLSV, the use of long-term debt by both large and small firms is positively related to the level of government subsidies.
After Demirguc-Kunt and Maksimovic, Aivazian et al. (2001) examined the capital structure in 10 developing countries and concluded that debt ratios in developed and developing countries are determined by similar factors but that country-specific factors appear just as important. But, they do not specifically examine the role of legal structure or effectiveness. Then, Fan, Titman, and Twite (2003) examine leverage amount and maturity across 47 developed and developing countries and find evidence that the corruption level is positively associated with high leverage and with more short-term debt but they find no relationship between common law and leverage. At the same time, Gianetti (2003) considered the effect of legal rules, firm-specific characteristics, and the level of financial development on corporate financing decisions for a sample of private and listed European firms, and then documented a positive relation between access to long-term debt and strong legal rules and enforcement, the paper conducted that firms in countries that favor creditor rights are more leveraged and have a higher proportion of long-term capital. More recently, Modigliani and Perotti (2005) stress, for example, the role that law and its enforcement play in the development of financial markets. They show that firms use more external finance in jurisdictions where contracts are more tightly enforced. And in the same time, La Porta, Lopez de Silanes, Shleifer, and Vishmy (2005) using a cross-section of 49 countries, document that external finance, in the form of both external equity and debt, is more abundant in countries where the law and the courts grant more thorough protection to outside investors’ property rights.#p#分頁標題#e#
2.2 Empirical Link between the Qualities of the Institutional Infrastructure
According to Nijkamp (2000) infrastructure is defined as material public capital (roads, railways, (air) ports, pipelines etc.) and superstructure meaning immaterial public capital (knowledge networks, communication, education, culture etc.), again without specifying the proposed terms in sufficient detail. The present study investigates directly the empirical link between the quality of the institutional infrastructure-measured by the strength and impartiality of the legal system, the efficiency of the courts or the extent of corruption among government officials-and the rate of return that firms must promise to their investors in order to secure equity financing.
A few papers have explored this link indirectly, by focusing on the corporate-valuation effects of legal and judicial institutions. They exploit the fact, for given stream of expected dividends; a company’s valuation is inversely related to the required rate of return on its shares. La Porta, Lopez de Silanes, Shileifer, and Vishny (1999), using company-level date from several countries, show that corporate valuation (as measured by the price-to-cash-flow ratio) is positively related to measures of shareholder rights’ protection. In the same time, Ferson and Harvey (1999) argued that, before concluding that a significant coefficient on a variable other than beta represents a rejection of the traditional CAPM, one needs to make sure that the variable itself has no informational content for the cross section of betas, whose true value is, after all, unobservable. And Pagano and Volpin (1999) highlighted the detrimental effect on investment and growth of widespread corruption among government officials. Several recent papers in the law and finance approach to corporate governance have narrowed their focus on the interactions between legal institutions, financial development and growth.
Then Lins (2002) documents that, in a cross-section of firm-level date from emerging markets, agency problems (as captured by the wedge between the control rights of the management group and their cash-flow rights) have a negative impact on companies’ valuation. He also finds that pyramids and cross-shareholdings have a stronger negative effect on firms’ value in countries where shareholders are less protected by the law from the opportunistic behavior of managers. Later on, Buehler et al (2004) investigate how various institutional settings affect a network provider's incentives to invest in infrastructure quality, indicated that under reasonable assumptions on demand, investment incentives turn out to be smaller under vertical separation than under vertical integration, though we also provide counterexamples. The introduction of downstream competition for the market can sometimes improve incentives. With suitable non-linear access prices investment incentives under separation become identical to those under integration.
The present analysis differs from these latter two in two main respects. First, cast the investigation in a traditional asset pricing-framework. This allows a more coherent consideration of risk as a determinant of expected returns and hence companies’ values. Second, identify the effects of institutions on expected returns using a panel data approach. This allows us to cope with the pitfalls of cross-country studies, resulting from possible omission from the analysis of important country-specific factors.#p#分頁標題#e#
2.3 Effect on the Cost of Equity Capital
Back to 1980s, Merton (1987) stressed, for example, the role that law and its enforcement play in the development of financial markets. They show that firms use more external finance in jurisdictions where contracts are more external finance in jurisdictions where contracts are more tightly enforced. Later on, Bhattacharya and Caouk (1999) investigate the effect on the cost of equity capital of insider trading regulation using asset pricing methods, they show that, while the mere existence of laws prohibiting insider trading is ineffectual, their enforcement reduces the risk-adjusted expected return on equity. Then Solnic (2000) explored the empirical link between financial markets and growth. Then use industry-level data to test the hypothesis that firms and industries that are more dependent on external finance tend to grow faster in countries where financial markets are better developed. Following that Richardson and Welker (2001) tested the relation between financial and social disclosure and the cost of equity capital for a sample of Canadian firms with year-ends in 1990, 1991 and 1992, then they found that, consistent with prior research, the quantity and quality of financial disclosure is negatively related to the cost of equity capital for firms with low analyst following. Contrary to expectations, there is a significant positive relation between social disclosures and the cost of equity capital. This positive relationship is mitigated among firms with better financial performance. They considered some biases in social disclosures that may explain this result, and they also noted that social disclosures may benefit the firm through its effect on organizational stakeholders other than equity investors.
More recently, Chen et al (2003) examined the effects of disclosure and other corporate governance mechanisms on the cost of equity capital in Asia's emerging markets with newly released surveys from Credit Lyonnais Securities Asia (CLSA), found that both disclosure and non-disclosure corporate governance mechanisms have a significantly negative effect on the cost of equity capital. In addition, the effect of non-disclosure governance mechanisms is more profound than that of disclosure on the cost of equity capital. Specifically, after controlling for beta and size, when a firm improves its aggregate non-disclosure corporate governance ranking from the 25th percentile to the 75th percentile, its cost of equity capital is reduced roughly by 1.26 percentage points, while the corresponding reduction in the cost of equity capital for the same improvement in disclosure is 0.47. Finally, they found that country-level investor protection and firm-level corporate governance are both important in reducing the cost of equity capital. Our findings suggest that, in emerging markets where infrastructural factors, such as the legal protection of investors and the overall level of corporate governance, are not well established, reducing the expropriation risk by strengthening overall corporate governance appears to be more important in reducing the cost of equity capital than adopting a more forthright disclosure policy.#p#分頁標題#e#

Then, Skaife et al (2004) investigated the extent to which governance attributes that are intended to mitigate agency risk affect firms' cost of equity capital, this paper examined governance attributes along four dimensions: (1) financial information quality, (2) ownership structure, (3) shareholder rights, and (4) board structure. Then they found that firms reporting larger abnormal accruals and less 留學生dissertation網(wǎng)transparent earnings have a higher cost of equity, whereas firms with more independent audit committees have a lower cost of equity. They also found that firms with a greater proportion of their shares held by activist institutions receive a lower cost of equity, whereas firms with more blockholders have a higher cost of equity. Moreover, they found a negative relation between the cost of equity and the independence of the board and the percentage of the board that owns stock. The results supported the general hypothesis that firms with better governance present less agency risk to shareholders resulting in lower cost of equity capital.

Later on, Vishmy (2005) used a crosssection of 49 countries, document that external finance, in the form of both external equity and debt, is more abundant in countries where the law and the courts grant http://www.ttc-switch.com/Thesis_Tips/Reference/Literature_Review/more thorough protection to outside investors’ property rights. If countries with better protection of shareholder rights were also safer investment havens for an international asset manager, then it would not be surprising that companies in those countries fetch higher valuation, irrespective of agency problems. And then, Hardouvelisa et al (2007) shoed that during the 1990s the process of gradual economic and monetary integration, which eventually led to EMU, also resulted in a reduction in the equity cost of capital. A similar reduction was not present in the three EU countries which chose not to enter the Euro zone. There was also a strong convergence in the cost of equity across the different countries within a given industrial sector, but little convergence across the different sectors of a given EMU country. An implication for portfolio management is that country effects are becoming less important and sectoral effects are becoming more important.